Cryptocurrencies – A 21st Century Financial Innovation
Simply put, cryptocurrency is digital money that operates independently of a bank and can be used in ways similar to cash around the world. However, the digital nature of these new currencies adds some benefits that appeal to consumers and have led to their increasing popularity.
While it can be easy to get caught up in the excitement and potentially lucrative nature of cryptocurrencies, it is important to understand how they work as well as their positives, negatives and risks.
A “cryptocurrency” acts as money in an electronic payment system in which transactions are validated by a decentralized network of computers rather than a third-party intermediary, such as a bank or other financial institution. The use of this financial technology (or FinTech) potentially creates certain benefits, poses certain risks, and raises a number of questions for policymakers.
A central difficulty with sending payments electronically is the “double spending problem.” Sending an electronic message or digital file directly from a payer to a payee in the hopes that it will act as a transfer of value is problematic. One reason is because payees cannot confirm that a payer has not sent that same message or file to multiple other payees. Because money in such a system can be double or triple spent, it would not retain its value.
Traditionally, this problem has been resolved by involving at least one centralized, trusted intermediary—such as a private bank, government central bank, or other financial institutions. The trusted intermediaries maintain ledgers of accounts recording how much money each participant has. To make payment, electronic messages are sent to an intermediary, instructing each to make the necessary changes to their ledgers to transfer value from one account to the other.
In 2008, Bitcoin created a new solution to the double-spending problem through the use of blockchain technology, which is now frequently used to enable other types of cryptocurrencies. Blockchain uses cryptography, file sharing and user agreement to ensure (a) that each transaction is secure, (b) that the groups of transactions that form blocks are secure, and (c) that the entire ledger (or blockchain) is secure. Through this system, parties that do not trust each other can nevertheless exchange value without a centralized intermediary because they trust the decentralized network and its cryptographic protocols.
How do cryptocurrencies work?
Cryptocurrencies act as money in these virtual platforms that maintain digital ledgers, which appear virtually impossible to falsely manipulate. The transfer of a cryptocurrency from one member of a network to another represents a valid transfer of value. The transfers are validated by the network’s members and not by a centralized third-party or a payment system.
Payers and payees in these networks are typically identified by a pseudonym (often a string of numbers and characters), called an address, which is linked to a public key. They also need a password, called a private key, in order to process a transaction. The address identifies to the users of the blockchain that the identity controlling the public key owns cryptocurrency, which can only be used when they apply their private key to it.
Because of the platforms’ security protocols, losing the public or private key often means losing access to the cryptocurrency. Together the public and private keys are sometimes called a wallet in which an individual’s cryptocurrencies are stored when the individual is not using them.
People may “mine” certain cryptocurrencies by earning newly created units of the currencies by performing certain work for the platform, such as validating incoming transactions. Alternatively, people can acquire cryptocurrencies on exchanges with payment of official government-backed currencies or other cryptocurrencies.
Cryptocurrency ledgers are believed to be mathematically secure, but vulnerabilities in wallets and exchanges can be exploited, causing losses for individuals and exchanges.
One likely reason cryptocurrencies have recently become a prominent issue is the sudden appreciation (and subsequent depreciation) in their value.
Traditional monetary and electronic payment systems involve a number of intermediaries such as government central banks and private financial institutions. To carry out transactions, these institutions operate and maintain extensive electronic networks and other infrastructure, employ workers, and require time to finalize transactions. Cryptocurrencies aim to provide a payment system that is more efficient, faster, and less costly. In addition, the anonymity of transactions (because of the use of (pseudonyms) offers greater privacy that could be valued by some users.
To learn about the potential obstacles of cryptocurrencies, please see our blog titled “Cryptocurrencies – Potential Obstacles and Policy Issues.”
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